These Stocks Rose An Average Of 500% -- Is The Bubble About To Burst?

Joseph Hogue's picture

Tuesday, December 2, 2014 - 1:30pm

by Joseph Hogue

The five-year bull market, which has seen the S&P 500 rise more than 200% since the March 2009 low, boosted share prices in virtually every sector. A stable U.S. economy gets much of the credit.

As has been the case throughout the bull market, some investors are expressing concern that the bull may be getting tired, while others see more gains ahead.

“Stocks are getting expensive, but higher analyst expectations for forward earnings justify the prices,” say some pundits. Others note that the rally is fueled by an expansion of credit and liquidity that will take prices higher.

Frankly, it’s hard to call market tops and bottoms, but we do know that stocks that rise the fastest often fall the hardest during a pullback. And right now, shares of our nation’s railroad operators are looking especially vulnerable. Three stocks in particular rose an average of roughly 500% since March 2009.

To understand why caution is advised, you need to turn the clock back to 2007 -- two years before the bull market began. At the time economists pointed to limited supply and surging demand to rationalize optimism for railroad shares.

Is 2015 The Year Rail Carriers Derail?
To be sure, this industry has a number of tailwinds right now. For example, rising volumes of crude oil are bypassing pipelines and being shipped on rail-based tanker cars.

Yet just as costs from regulatory oversight and capital expenditures rise, demand may start to weaken for transportation of crude by rail.

Environmental concerns have already led California to pass a $0.065 fee on every barrel of oil entering the state, and other states may follow suit.  The increase in oil-related consumption comes at a time when railroads are still working off of systemic delays that were created during last winter’s cold snap.

In a bid to reduce bottlenecks and ensure rail’s competitive positioning, infrastructure spending is soaring. The American Association of Railroads reported in April that rail capital expenditures jumped to $25.1 billion over the last two years -- the highest on record. Rail carriers are spending 17% of their revenue on capital expenditures, nearly six-times the average 3% spent by manufacturing firms.

The United States is forecast to add 5.2 million barrels per day of pipeline capacity over the next six years, according to the Interstate Natural Gas Association of America. This is while the International Energy Agency projects oil production will increase by just 2.45 million barrels per day over the same period, to a total 11.1 Mbpd.

Another factor that may lead to less rail demand is cost. Transporting crude by rail can cost up to $10 more per barrel than via pipeline. This assumes that oil production will continue to increase.

Goldman Sachs expects the price of West Texas Intermediate -- the U.S. benchmark for oil -- to remain pressured between $70 and $75 through the first quarter 2015. At $75 a barrel, 19 U.S. shale regions are unprofitable in Kansas, Oklahoma and Texas. This could slow production and weaken rail demand in the near-term as well.

Even if rail demand remains high, surging capital expenditures will limit shareholder cash return over the next year or more. Capital expenditures will eventually increase capacity, but it may come just as new oil pipelines come online.

Canadian Pacific Railway Ltd (NYSE: CP) could be the poster-child for the boom with shares up 716% since the bull run began in 2009. Shares trade for 36.8 times trailing earnings, well above the industry average multiple of 21.9. Meanwhile, sales and profits are expected to rise 10% and 31%, respectively, in 2015.

Another key concern: Management is looking to acquire peers even as valuations get expensive. The company announced the cancellation of its merger talks with CSX Corp. (NYSE: CSX) in October due to possible regulatory hurdles. I doubt it will keep the company from pursuing smaller acquisitions.

For its part, CSX has seen its shares higher by 443% since the 2009 market low and now trades just under the industry average at 20.3 times earnings. CSX’s sales and profits are expected to grow 4.5%, and 13.5%, respectively, in 2015. Notably, shale oil-related carloads represented 70% of CSX revenue growth in the first half of 2014. Any weakness in shale drilling could hit the company hard and cause sentiment to waver.

While weaker industry fundamentals would still hit Norfolk Southern Corp. (NYSE: NSC), shares trade for a more reasonable 18.1 times earnings, even as the company’s 2015 growth profile is similar to that of CSX. Shares lagged industry peers on the way up, increasing 334% since March 2009. The more attractive share price may help support the stock on the way down as well.

Most of the potential hurdles for rail carriers won't likely come to a head until mid- or late next year, but that does not mean the shares will be safe until then. Stocks are priced on earnings and sales growth well-above the longer-term average and any cracks in the story could send investors bolting for the exit.

Risks To Consider: Carrier revenue from oil production will likely remain high into next year, but investor sentiment could weaken ahead of actual industry economics. Deal making across the space could push certain companies higher, but gains may be short-lived.

Action To Take --> Investors should consider taking profits in rail carriers heading into next year and position in relative value plays like Norfolk Southern against more expensive names. It’s been a great run, but investors would do well to remember other bubbles and leave the party early.

My colleague Dave Forest -- editor of StreetAuthority's Scarcity & Real Wealth newsletter -- travels all over the world to find opportunities in commodities most investors haven't even heard of yet. Dave recently found a huge opportunity that could earn 29% gains by February... but only if you invest by December 10, 2014. Get all the details here.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.